Archive for month: November, 2011

For the last few years, there have been tax breaks for investors with long-term capital gains, as well as for qualified dividend investors. As part of a tax deal at the end of 2010, favorable tax rates on qualified dividends were extended through 2012, so the same tax rates apply to qualified dividend income as apply to long-term capital gains. Right now, that means that those in the 10% and 15% brackets pay no taxes on such income, and those in higher brackets pay 15%.  (Everything could change starting in 2013, depending on what Congress decides to do.)

This situation means that many people have been enjoying tax-free dividend income – as long as it’s qualified. You need to have an understanding of qualified dividends vs. unqualified dividends if you expect to fully take advantage of your tax status:

Qualified Dividends

Information on dividends, and how they are taxed, can be found in IRS Publication 550. “Qualified” status is awarded to dividends that are paid by a U.S. corporation, or a properly qualified foreign corporation. In most cases, the dividends you earn as a result of stock held in most U.S. C corporations are considered qualified dividends. Additionally, you must meet a specific holding period.

In order to be “qualified,” the IRS says that you must own the stock for more 60 days during the 121-day period beginning 60 days prior to the ex-dividend date. As long as you keep things relatively simple, this is fairly easy to figure out. Things start to get a little more difficult when you use option strategies. You might need a tax professional to help you sort things out in more complicated scenarios.

Non-Qualified Dividends

Even if your stock holdings meet the requirements above, there are some dividends that are never treated as “qualified.” You should be aware of these dividends, so that you don’t make the mistake of paying less in taxes than you owe. Here are the items that the IRS says will never be treated the same as “qualified” dividends:

• Capital gains distributions.
• Dividends paid from tax-exempt corporations or famer’s cooperatives.
• Dividends received from deposits with credit unions, building and loan associations and financial institutions that are structured similarly.
• Payments received in lieu of dividends, if you have reason to know that they are not “qualified” dividends.
• Dividends paid on ESOPs maintained by corporations for their employees.
• Dividends from stock shares that require you to make related payments for positions that are in substantially similar or related properties (such as in the case of a short sale).
• Shown dividend payments in box 1b of Form 1099-DIV from a non-qualified foreign corporation.

If you have questions about the status of your dividend payments, it’s a good idea to double check with a tax professional or investment professional. Non-qualified dividends are taxed at your normal tax rate, so if you are in a marginal tax bracket above the 15% level, you will have to pay that tax rate.

When it comes to dividend stocks, the general rule is buy and hold. So, a number of people believe that they need to stick with a dividend stock, even after a dividend cut. And, while abandoning a stock at the first sign of a small dividend cut may not be quite your style, any cut should provide you with food for thought.

Reasons a Dividend Cut Matters

When a company cuts its dividend, it matters. It’s true that a dividend aristocrat that stops raising its dividend each year, and falls off the Dividend Aristocrats list, can be a concern. But a company that cuts its dividend – or eliminates it altogether – is something different. This can be an indication that things are going to change, and maybe not for the better. Here are some things a dividend cut can presage:

1. Losing market share: In some cases, a company that has to cut its dividend does so in response to the way its market share is shrinking. When that happens, that might mean that the company is losing ground – and may not be able to provide the kind of growth that will result in sustainable dividends in the future.
2. Cash problems: A company that cuts its dividend often doesn’t have the cash to continue to give some of its profits to shareholders. This can mean that revenues have fallen (due to market conditions or to some other problem), or that expenses have risen. It can also be a sign of mismanagement. In any case, cash problems can be an indication that problems are on the way. A dividend cut can be indicative of problems.

Before you get too hung up on dividend cuts, though, consider the situation. Following the global financial crisis, almost all financial institutions cut their dividends. They were all on shaky ground, and cash was a real problem. However, now many banks are starting to raise dividends again – although it might be years before dividends recover. In some cases, a dividend cut is only temporary, and dividends are likely to be raised again. However, if you are relying on dividends for stable income, a stock that regular cycles through cutting and raising dividends is usually not your most reliable choice.

On the other hand, though, it is important to consider that there are companies out there that are managed so well, and have enough market share, revenue, and profitability that they can keep raising dividends, even during times of economic upheaval when other dividend stocks are faltering. (This quality is what makes the dividend aristocrats so attractive to many.)

Getting rid of a dividend stock is a serious decision. A dividend cut might be a sign that the company is in trouble, and it might be time to unload. However, before you decide to sell, it’s a good idea to consider your options, and make sure that you can replace the stock with another dividend stock. One that might provide you with better performance and more reliable dividends.

Value investing is back.  Investors are flocking to anything with perceived value to avoid the market swings we are seeing every day.  There are many different methods and formulas you can use to identify undervalued dividend stocks.  The dividend growth model is one that we have mentioned before.  Discounted cash flow and comparing current dividend yield to average yields are also often used.

We didn’t use any of those models to identify these three stocks.  Instead we first found stocks trading at a price to book value ratio of less than 1.  We further filtered that list down by removing any stock with a P/E and PEG ratio above their specific industry average.  It’s important to compare P/E ratios to industry averages instead of index averages because not all industry trading at the same level.

After drilling down into value we then sorted stocks by dividend yield to only include those with a yield of 3% or more.  We ended up with over 20 stocks many of which are REITs.  Each of these stocks has a story and it’s important to do your homework to determine if these fundamentals are predicting a big upside or a possible problem at the company.

A good example would be two stocks you’ve probably heard of before – Whirlpool and Computer Science Corp.  Both had disappointing earnings results recently and have analysts concerned about future growth.  Other stocks such as Transocean have solid fundamentals, a high yield and the backing of many analysts making it one of the best dividend stocks on the list.

It’s true that an income portfolio can be a good way to provide yourself with a stream of passive income that can support you in the future. However, it is important to be careful. If you rely too much on dividend income, you might wind up in a difficult situation.

Main Issue with Dividends

The main issue with dividends is that they can be cut – or even eliminated – at any time. Companies are not obligated to keep paying dividends. They can get rid of them suddenly, or cut them during tough economic times when cash gets scarce. As a result, if you are relying too heavily on dividends, you could find yourself facing a significant decrease in your income if the investments in your portfolio suddenly cut their dividends.

At this juncture, especially if you are retired, or don’t have other sources of income, you might be forced to sell some of your stocks. In some cases, this can be a very inconvenient time because the stock price might have dropped as well. So, you will be forced to sell your holdings in order to get the cash you need, but you won’t perhaps, get as good a return as you would have liked.

Protecting Your Income from Dividend Cuts

As a result of this possibility, it is important to protect yourself from dividend cuts. Many people think that you have to be either a total return person, or a dividend person. The truth, though, is that you can be both. You can create an investing plan that allows you to create a portfolio that allows you to build up, on the one hand, investments that you know you will likely sell at some point, as well as create a dividend portfolio that provides an income stream.

You can also protect yourself to some degree by choosing your dividend stocks carefully. Some investors like the dividend aristocrats because the companies involved have raised dividends every year for at least 25 years in a row. With dividend aristocrats, there is a smaller chance that the dividend will be cut, much less disappear altogether. Of course, the possibility of a dividend cut or elimination is always there, but it is smaller.

Diversify Your Portfolio

It is also possible to diversify your dividend portfolio so that you have different types of stocks involved. That way, if cuts are more sector-based, you will still have other investments that will hold up, and possibly help make up for a dividend cut.

And, of course, you can prepare your finances by building up an emergency fund of some sort. That way, if you end up the victim of dividend cuts, you can draw on your emergency fund while you wait for your dividend stream to recover, or wait for the markets to improve so you can sell some of your investments later. You can also start a side business, or cultivate some other source of income to help provide you with a stream if dividends are cut.

Being prepared with different options can help you avoid the problems related to dividend cuts, and better prepare you for a successful financial future.

When you are looking for stable performance, and regular dividend increases, one place to start is the list of dividend aristocrats. Stocks can’t be considered dividend aristocrats unless they have increased their dividend payouts at least once a year for the past 25 years. If a stock misses a year, it is off the list – and it takes another 25 years to get back on. These safe dividend stocks are often considered the cream of the crop by investors who want regular returns, and a reasonable expectation of income increases.

Considering the Company

One of the reasons dividend aristocrats can be so attractive is because it says something about the company. A company that can consistently afford to pay cash back to stockholders – and increase the amount given to shareholders each year – is usually in pretty good financial shape. Think about it: Because of what it takes to become a dividend aristocrat, it means that these companies continued to increase their dividend payouts even during recessions and stock market troubles.

If you are looking to invest in a company that is likely to survive economic downturns and market volatility, a dividend aristocrat might be just the thing. Not only are you likely to see increases in dividend income, but you are likely to, over time, see an increase in stock price, resulting in gains when you finally do sell.

Things to Keep in Mind

Of course, it is important to remember that dividend aristocrats might not always remain so. Companies can decide not to increase dividends – or even cut them – at any time. This means that a dividend aristocrat may end up off the list. When this happens, it is vital that you consider the situation surrounding the fact that a company is off the list. What has changed? Is the management changing? Are profits falling? Removal from the list can be an indication of trouble in some cases.

Also, be aware that investing in dividend aristocrats may not provide you with a huge income – especially immediately. It takes time to build up a dividend portfolio. Realize, too, that some dividend aristocrats have relatively small yields. Remember: These are stocks that raised payouts each year. However, they might not have started with a very high payout, and they need only increase the payout by one cent in an entire year to make the cut of being a dividend aristocrat. You can’t expect a huge income immediately from a portfolio heavily favoring dividend aristocrats.

Bottom Line

Even though there is no guarantee that a dividend aristocrat will always remain so, it is important to note that you can increase your chances of stability when you invest in a dividend aristocrat. Consider your options, and consider how dividend aristocrats might help your situation.